Tuesday, December 11, 2018

UK Plan to Leave EU Collapses in Pool of Recrimination

As I write this, the plan for the U.K. to leave the EU lacks support in Parliament. Vote-counters estimate that two thirds of Parliament would vote against the plan. The vote that had nearly been placed on the schedule has been canceled. A vote on a “softer” alternative plan has also been called off. As of today, the government has no plan at all. It is probably too late to approve any measures to manage the UK exit from EU before the date that is scheduled to happen. How did we get to this point?

Looking at it one way, this is a situation set up by the laws of the EU. The law does not make it easy to negotiate a phased withdrawal. In practical political terms, this requires a consensus among EU members and enabling legislation passed by the leaving country. That is a broader base of agreement that politicians are used to dealing with.

Looking at it another way, you can place all the blame on the British Prime Minister. There is only one game for leaving the EU: prepare a consensus plan from the beginning, then persuade all parties involved that it is the only possible plan. The British government did the exact opposite. It delayed for a year with no plan at all and no serious study of the issues, then presented a plan intended to abuse its position to gain advantage. By some miracle, this plan was approved at the EU level, but there was never an effort to sell it to voters or Parliament. People are just now learning the details, and when leaders ask why certain things were done a certain way, there is no explanation. That is not the way you persuade stakeholders that your plan is the only possible solution. Doing so requires being able to explain why any possible alternative would create terrible problems somewhere that no one has a solution for. If you intend to pass a plan by decree without the ability to defend it point by point, it will go badly.

I don’t think anyone knows where the “Brexit” process goes from here. There is no constructive dialog going on in Parliament that could work out the issues involved. Some observers believe that the U.K. will remain in the EU, not just because it is too late to fix the plan, but also because the referendum that approved the U.K. exit from the EU might not be legally valid. Some who support the EU exit or who worry about the EU coming apart at the next global economic crisis now think this is the wrong time. Such a complicated maneuver should not be done without leadership, and there is no real leadership in the U.K. right now.

But the other alternative is the “hard Brexit” suggested by EU law, followed by piecemeal measures after the fact to try to undo some of the damage. This remains a very real possibility, but the human impact would be severe. A large number of workers, on the order of a million, would be affected directly. These are workers with jobs in foreign countries. They could lose their jobs immediately or lose access to their jobs as soon as they travel between countries. There would be a recession in London and possibly in all of Britain as a hundred large companies move offices to other countries. The main reason this scenario remains a possibility is that under the law, “hard Brexit” is what happens by default if British policy continues its current drift and no further formal action is taken.

The statement below from EC President Donald Tusk is indicative of the state of affairs as of last night. No one knows what to do.

Monday, December 10, 2018

The Electric Truck Transition Will Go Faster Than Electric Cars

It’s taken a century for the electric car to get a good, strong foothold in the market. Electric trucks are a harder problem to solve because a truck requires so much power compared to a car. Therefore, it will take electric trucks an even longer time to start to build market share. That’s the conventional view of the upcoming transition in trucks, from the viewpoint of the auto industry. But that is the wrong way of looking at it.

The real obstacle holding back electric vehicles is the battery. For the ideal electric vehicle, the battery should be smaller and lighter than the batteries used in vehicles today — and not just a little smaller and lighter. To overtake the internal combustion engine on its own terms, batteries should be about one third smaller and one third lighter. To compete strongly in initial selling price for cars, batteries should also be about one third less expensive.

The most important point to understand about the transition to electric vehicles is that there is nothing to stop this advance in battery technology from happening. It is a simple, well-defined problem in materials engineering, so simple and so well-defined that the answer could arrive on any given day and be out on the road in prototype form one week later. How quickly it could go into mass production is a more complicated question, and experts have varying opinions, but there is a consensus that it will happen sometime between 2019 and 2060.

Note, however, that no such breakthrough is necessary for electric cars to dominate the market. As I have written before, electric cars are so much more durable than fuel-burning cars that they can eventually dominate the roads with a market share as low as 2 percent at the point of sale. It is the same way that LED light bulbs dominate home lighting even though about half of light bulbs sold are still the low-efficiency fluorescent and incandescent types. The product that lasts longer holds its space in the world for longer. The product that lasts only a few years has an exaggerated share of product sales because it is constantly being replaced.

Already electric cars are at or approaching a 1 percent market share, so the pace of deliveries does not have to pick up much for them to take over the roads in the long run.

Something that has always separated cars from trucks is market concentration. Roughly 50 well-known brands own virtually the entire car market. That has never been the case with trucks. There are hundreds of truck manufacturers. The cost of entry is relatively low. Any automotive engineer and mechanic with a drive-in warehouse space can build their first truck. Truck building does not require an assembly line or even a factory.

One way of understanding this is to look at how long trucks last. I remember being amazed at the stories of cars that ran for 200,000 or 300,000 miles. For a pickup truck to be equally amazing, it has to pass 1,000,000 miles of driving. That is because, in a practical sense, a truck can be completely rebuilt, or as much as necessary, in the repair shop. There is no part of a truck that can’t be replaced if you want to do the work.

This also implies that, with only a moderate level of guidance from an engineer, a mechanic could remove the engine and fuel tank from a truck and replace them with a battery and electric drive. This means that electric trucks could get a foothold in the market without even having a manufacturer. For all I know, there are already well-tested published designs for converting a Chevy Van or Ford F-150 pickup to electric. If those do not yet exist, they will be coming before long.

There is nothing to stop engineers from taking existing truck components and putting them together with components created for electric cars to create an electric truck. It is probably too complex a problem for a single engineer working alone, but certainly not too complex for a small number of skilled engineers collaborating over the Internet. This means that as soon as problems are solved in electric car design, the same solutions are available for use in trucks.

So electric trucks would be inevitable even if there were no manufacturers. But there are manufacturers, such as Rivian, a tiny company profiled by CNN Business. The small scale of any electric truck manufacturing operation tells you how small the cost of entry is. That means there will be many more — so many companies competing that the market leaders in fuel-burning trucks may not be able to catch up once the market starts to shift.

Companies like Ford and General Motors are starting to shift away from fuel-burning cars because it is already evident that that market is getting away from them. They will try to make the transition in SUVs and light trucks. But they will have to move quickly. If they try to manage the transition on their own schedule, they will wake up one morning to discover that that market is gone too.

Tuesday, December 4, 2018

General Motors Cuts Back on Fuel-Burning Cars

We can add General Motors to the list of auto manufacturers scrambling to catch up with the changing car market. In a series of adjustments rumored in November and since confirmed, General Motors will close half of its car manufacturing plants in North America over the next three years, and the rest may last only a few years longer. Some observers see General Motors shifting car manufacturing to overseas factories, but that is a false picture created from mistaken assumptions. The factories that remain overseas will also have to cut back in the near term and are also at risk of being shut down in the coming years as demand for fuel-burning cars dries up.

I have seen complaints that say General Motors is cutting back too much, too soon, and politicians in both the United States and Canada have suggested that the company might be persuaded to reconsider or delay its cutbacks. This shows how poorly people remember history. It was just this mistake that brought the old General Motors to the brink of bankruptcy in 2008, leading into its 2009 bankruptcy reorganization that created the current General Motors. People, I think, forget the time scales that a major auto maker must deal with. General Motors has to plan out its designs, supply chain, and manufacturing capacity three years in advance. It is far more costly if such a large and cumbersome organization has to move faster than that. What will the demand for fuel-burning cars be three years from now in the 2022 model year? To be blunt about it, there is no assurance that anyone in the world will still be buying new fuel-burning cars at that point. By then, demand for fuel-burning cars will have fallen off so much that, in theory, the entire demand could be met with used cars. General Motors is betting that many of its wealthier customers will still be buying its new cars at that point, and it seems like a good bet to me, but when you look at how much money is at stake on what is essentially a consumer whim, it is understandable if the company is nervous.

As it closes factories, General Motors is eliminating many of its car models. The list notably includes the Volt, the ill-advised hybrid design that combined an electric drive with a gasoline-powered generator. It was a money-losing proposition from beginning to end, undertaken mainly as a public relations stunt. The Volt got the attention the company was looking for, but it never gained the credibility its designers had hoped for.

Some of the auto industry speculation is that people will be less interested in owning cars as new designs make them more reliable. We may become a nation of renters when it comes to cars. This doesn’t necessarily mean that drivers will drive less, but there will be fewer total cars, with fewer cars sitting idle on any given day. This would seem to imply less manufacturing and more maintenance in the future of cars, though it is hard to be sure. The important thing to note is that fuel-burning cars will not be cost-competitive whether people are renting or owning.

Consider the risks if manufacturers cut back capacity too quickly. Some of the remaining factories might have to work two shifts to make enough cars. There could be a shortage, prompting a few buyers to go for used cars instead. This is not so bad. Balance that against the risk if manufacturers keep more capacity than they need. There could be billions of dollars in unsold inventory in dealer lots and in rented parking lots in Detroit. The auto manufacturers could go bankrupt and all their factories could close. That is a bigger problem, and that is the scenario that General Motors is trying to guard against.

While the focus is on cars right now, light trucks will follow just a few years later as battery technology advances and scales up, and heavy trucks just a few years after that. What happens to cars will eventually happen to the rest of the industry.

The political rumor machine has it that the United States will eliminate all subsidies for efficient and low-emission vehicles. That move probably makes sense at this point. Subsidies may have a place as a way to get a new approach off the ground. It hardly makes sense to use them as a way to speed the old guard into bankruptcy.

Monday, December 3, 2018

Retail Traffic Picks Up

A full week has gone by since Cyber Monday, and there are a few answers about Black Friday and the current holiday shopping season. Retail traffic has picked up since Black Friday. The Saturday that followed Black Friday was nearly as busy at retail as Black Friday itself, from what I could see, and that is a striking departure from the last few years. Cyber Monday showed a healthy increase in purchases from last year. The usual pattern of after-work shoppers was very much in evidence where I was last Wednesday and Thursday. Then Friday and Saturday, a week after Black Friday, were at least as busy as Black Friday was. On both weekends, shopping dropped off when Sunday arrived.

Black Friday, then, is a shopping holiday in search of a purpose. The gimmick of getting shopping families out in the middle of the night can’t be very profitable for the retailers who go all out to make it happen, nor could it be good for employee morale. The use of high-profile loss leaders on Black Friday isn’t working if shoppers get their purchases before 2 a.m. and head home, not to return to the same store for the rest of the year.

The idea of Black Friday won’t go away, but retailers are approaching it all wrong. Instead of trying to make a few one-off sales to the most hard-core bargain shoppers, retailers might do better to try to appeal to family shoppers on a day when students are not in school. A sensible Black Friday special might be on an item that parents will buy for their children with the children present — children’s winter coats, boots, shoes, and socks, perhaps.

Black Friday fell especially early on this year’s calendar, and that could have been a factor. Perhaps the low traffic on Black Friday reflects a growing split in Christmas shopping, in which one faction tends to complete Christmas shopping before Thanksgiving and the other postpones most purchases until the last two weekends before Christmas. If this is what is happening to Christmas shoppers — and it is consistent with what I am seeing — then Black Friday falls squarely in the dead zone between these two groups, presenting a special difficulty in appealing to either group. Looking at this trend, the prospect of renaming Black Friday as Don’t Buy Anything Day looks like it might have a chance.

Does the bleak Black Friday mean that Christmas shopping is reversing its trend of the last two decades, to shift from November to December? I don’t think that’s possible. A plurality of shoppers buy presents that have to be shipped to their recipients, and consumers have come to accept that such shipments have to be sent out no later than the first week of December to have reasonable assurance of arriving in time for Christmas. The people still shopping on December 7, then, either are buying just for their own household so that nothing has to be shipped or have decided to accept the possibility that their gifts might arrive several days late. I don’t see how either rationale for late Christmas shopping could increase suddenly or by very much. The current mail crisis in Canada, in which a job action has resulted in a four-week backlog of packages in the mail, is a reminder of the risks that gift-givers face by trying to do their shopping in December.

Another observation from the current shopping season is the large number of major retailers with extended online outages on Cyber Monday and the five days before. This comes after a relatively clean, trouble-free online shopping season in 2017. Maybe 2017 was a glitch, but the way I see it, the more likely explanation is that retailers have become overconfident after a clean 2017. One indication of this is that it appears that the cross-selling engines used by retailers provided the excess load that crashed web sites leading into Cyber Monday. On some sites, I have heard, the product pages loaded just fine at the same time that the front page, category pages, and search pages remained inaccessible for hours at a time. This is surely a sign that a cross-selling strategy that targeted users arriving at these pages was overloaded by the near-record volume of shoppers. Deciding what product to recommend to a specific known customer is a computationally intensive real-time process, but it was a mistake for retailers to lean so heavily on their cross-selling algorithms that their sites became inaccessible to customers who only wanted to buy a specific product. There is nothing commercially wrong with having such an advanced cross-selling strategy, but by next November, retailers will be looking for an approach that can fall back to something more efficient instead of shutting the site down when shopper traffic exceeds server capacity.

The disappearance of the Black Friday crowds has far-reaching implications for retail capacity. For a lifetime, retail floor size and parking area has been tuned to the Black Friday crowds. This year there were no Black Friday crowds. Few parking lots were more than 25 percent full at any point, and that means that the stores too were uncomfortably below their shopping capacity. Stores and parking lots alike could be half as large and still easily accommodate the peak shopping crowd of the year. Alternatively, we could get by with half as many stores. More retailers will be looking to emulate the small footprint of specialty retailers like Gap, Apple, and Victoria’s Secret, and that could lead to a decline in total retail real estate. Another scenario is that retail chains resist the need to slim down, leading to a parade of retail-chain bankruptcies over the next decade.

Returning my attention to the current season, my feeling is that we hit a brief early-December lull through the middle of next week, followed by more hectic after-work, Friday, Saturday, and Sunday shopping periods. Christmas Eve, falling on a Monday with many workers having the day off, could be busier than usual.

Friday, November 23, 2018

What Happened to Black Friday?

I made a point of going out shopping today, and my reaction, in a few words, is: What happened to Black Friday?

For years I have attempted to assess the mood and energy level of holiday shoppers. I have not written so much about it this year now that I have reduced my own shopping and and am not out in the stores so often. My general impression so far this season, though, is strikingly different from recent years. Shoppers are more mellow than I remember seeing. They aren’t in a big hurry, don’t feel that they need to buy anything, and aren’t expressing much financial pressure.

This kind of shopper is good news and bad news for retailers, isn’t it? These are shoppers who can take their time to look at merchandise and who are able to buy. On the other hand, they have to be persuaded to buy, and it is hard to guess how that can be done. They will be perfectly happy to walk away empty-handed.

Today is Black Friday, and I went out to the stores at 10 a.m. and a second time at 3 p.m. I made purchases at three stores, visited several more, and drove past more than 100. Things just weren’t very busy anywhere. Busy, yes, but no more so than any Saturday in October when I saw people doing their Christmas shopping early so they could avoid Black Friday. Some parking lots were half full, but most, much less than that. No one had to look for a parking space at any store I saw. Most stores had only one or two cash registers open. If the level of traffic I saw today is any indication of the shopping season, retailers in general and Sears in particular are in some trouble.

My largest purchase was at the Thorndale location of Sears subsidiary Kmart, which is halfway through its store closing sale. I was chagrined at how few people were there when I arrived at 10 a.m. and took this photo of the parking lot. Remember, this is the most-hyped shopping day of the year, and it is the middle of the biggest and last sale in the history of this particular store. Almost no one was there. There were two cash registers and very short lines.

I had heard stories about bare shelves at Kmart stores, and my visit bore that out, but not in a good way. About 10 percent of the displays were empty or nearly so. I bought the last rope and nearly the last drill bits in the store. The grocery aisle did not have much left. Yet most of the store was excessively stocked, as if the company was planning on two or three times a normal level of seasonal shopping traffic. Even with store-closing discounts, most of this merchandise cannot possibly be sold if the store is to close days after Christmas as planned.

There were hundreds of racks holding fall and winter clothing. That must be millions of dollars of clothing in the store, and I did not see even one shopper looking at the clothing. Holding so much inventory that will have to be sold to liquidators a month from now is a disaster for a company that, in case you haven’t heard, is already in bankruptcy. Sears Holdings needs every Sears and Kmart store to have an above-average holiday season to have a chance of keeping stores open, and in the Kmart I visited there was no sign of that.

Though the near-empty Kmart parking lot would shock more than a few observers, traffic was not much better in the adjacent shopping center. The area was affected by an freak cold snap with high temperatures barely above freezing today. Retailers will tell you they like cold weather and snow piles because it reminds shoppers to buy winter clothing, but the effect is lost if everyone stays home.

Traffic had picked up slightly by the time I went out again, arriving at my first stops around 3 p.m. Traffic at many stores was no more than a regular business day, but some stores were especially busy. The two stores that had heavier traffic than I would expect to see on a Black Friday were department store Boskov’s and pet-supply store Petsmart. Each, I suppose, is family-friendly in a different way. I want to be careful not to understate the importance of a shopping day on which the schools are closed and families can go shopping together. These two stores aside, from what I saw, Black Friday was more hype than substance.

Some stores I visited had no Black Friday specials at all, despite having made a practice of it in previous years. The store that put the biggest Black Friday circular in my mailbox on Wednesday was Walmart, but its parking lot was only about one fourth full when I went by around 4:15 p.m.

I made special note of Barnes & Noble, one of the largest retail chains on bankruptcy watch this season. It had shoppers when I drove by, but there were plenty of empty parking spaces too. It was no more traffic than you would expect to see on a regular weekday evening, but surely today’s shoppers were buying more.

Has Black Friday disappeared from the calendar? I wouldn’t want to hurry to reach that conclusion based on my own observations. From what people are telling me, the real action was during the night. The hard-core shoppers were out as early as 7 p.m. the night before (yes, that’s Thanksgiving Day) to shop late into the night, or all night for some of them. At the major retail chains that had the most aggressive promotions, I am told, parking lots were more crowded between 11 p.m. and 3 a.m. than they were between sunrise and sunset. Some stores had parking lots more than half full in the wee hours of Black Friday, only to see them empty out before daybreak.

Even if overnight revenue was good, this is a sad and perverse situation. Six hours of heavy breathing in the middle of the night does not necessarily make up for a lost day at retail. What does it say about the state of retail that, with a set of bizarre and unpredictable incentives, they can get shoppers into the stores at all hours of the night, but they still can’t bring anyone in to buy during the day?

So was this lackluster Black Friday the high point of the shopping season, or will shoppers who stayed home today turn out to do shopping on another day when the weather is more favorable? I don’t believe history can be a guide. It is safe to say we have never seen a Black Friday like this.

Thursday, November 15, 2018

Overconfidence Stings JCPenney, Department Stores

When a close competitor fails, it is good news and bad news. The good news is that you might be able to pick up some of the customers. The bad news is that you too might fail from the same market forces.

Department stores that see the expected liquidation of Sears and Kmart as good news are missing the bigger picture. It is not just that department stores collectively will lose customer visits to Sears and Kmart during store closing sales. The whole department store concept is in decline. The mall concept is in decline. The question at this point is not how to stem the decline, but how to best manage it.

Target, JCPenney, and Macy’s have been the most overconfident in reacting to the decline at Sears and Kmart. The folly in this view was brought home with the new report from JCPenney, which saw a staggering decline in sales in the third quarter, down 5.4 percent. Inventory overhang continues to be a major concern — also down 5.4 percent, but that means inventory remains just as bloated as before when seen in proportion to revenue. A few quarters had looked promising at JCPenney with actual gains, however minimal, in same-store sales. This plateau may, in retrospect, be seen as an accidental result of the whims of popular culture in an otherwise directionless company. The stock hit an all-time low after the report and faces the risk of being delisted if things do not turn around in the next few months.

When comparing JCPenney to Sears, it is important to note that JCPenney is doing worse than Sears by most measures. Most importantly, the Sears brand still stands for something. JCPenney has changed direction so many times in the last quarter century, it no longer has a brand identity. The only reason JCPenney looks better at this point is that Sears went into bankruptcy.

If Sears and Kmart are suffering from inventories that are too thin, department stores in general will suffer from the overblown inventories of the overly optimistic stores. Those items will have to be discounted as soon as December arrives, putting pressure on every department store. The price pressure will be that much more intense if all Sears and Kmart stores are in liquidation by then.

Wednesday, November 14, 2018

Democracy vs. Olympics: Calgary Votes No

Another Olympic hosting effort has come to an end as it became clear that local citizens were opposed. CBC News reports 'The people have spoken': Calgary mayor confirms 2026 Olympic dream is dead after vote. Calgary residents voted on the question of whether the city should proceed with its attempt to host the Olympics. It was a decisive vote, with 56 percent of voters opposed.

The troubling thing about the Calgary bid to host the Olympics is how far the process went in spite of never attaining any meaningful legislative approvals and never having a significant level of local support. It seems as soon as a committee was assigned to study the possibility of the city hosting the Olympics, that process took on a life of its own, with no one able to put the brakes on when that was needed.

It was not the voters so much as a budget shortfall of several billion dollars that killed the Calgary Olympics. There is no doubt that the funding shortage, and the scenario of the city residents paying it off over the next forty years, helped persuade some voters to turn out and vote no. Had the Olympics hosting budget balanced, the plan might have gone ahead in spite of local opposition. Conversely, even if voters had voted yes, the hosting proposal could still have fallen apart because of a lack of funding.

What this saga suggests is that there is a fundamental conflict between the Olympics and democracy. Realistically, a city probably cannot host the Olympics or an international sporting event of similar scale unless it is done without letting the people have a voice in the process. When you look at the ethical implications of city taxpayers backstopping the finances for what is, in financial terms, a U.S. television show, that is reason enough for principled voters anywhere to vote no, assuming they are asked.

If the Calgary Olympics story gives you a sense of déjà vu, that may be because it so accurately duplicates the recent story in Boston. There, the budget shortfall was similar in scale, and it was the tireless efforts of community organizers focusing public opposition that brought that project to a stop. But as in Calgary, it was a planning effort that took place behind closed doors with no public support and very limited governmental approval. The thought in Boston was that a major event that would permanently scar the landscape of the city could be shoved down the public’s throat. It is a way of thinking so far removed from democracy that it is no wonder it ran into trouble.

The Olympics may be able to carry on a little longer by holding events in places that are more authoritarian, but eventually, the clash between Olympics and the public interest has to become an embarrassment, not just to the Olympics, but also to its supporters and sponsors. The long-term decline in the U.S. TV sports audience will undercut the prospects for the Olympics ever becoming self-funding. If the Olympics must be a money-losing operation, it really should be financed properly, by charitable donations, rather than by bait-and-switch and hot-potato tactics to cobble together public funding. The two-year cycle of searching for a city where people are gullible enough to agree to host is hardly a reputable way to run such an enterprise.

Friday, November 9, 2018

Muted Christmas-Season Hiring

Christmas-season hiring has been quiet in the United States, and no one is quite sure why. An obvious structural change is that Amazon is hoping to lean heavily on its own delivery network for the first time this quarter, giving UPS and FedEx Home Delivery little reason to project enormous growth over last year. A possible Sears and Kmart liquidation, the earlier Toys ‘R’ Us liquidation, a pattern of early-December layoffs of seasonal personnel in 2017, and a tight labor market are reasons for retailers to hold back on hiring this time around.

Walmart, the largest employer in the United States by some measures, says it will not be hiring any seasonal workers. Instead, its regular employees will be preparing for long hours of overtime during Thanksgiving week and the two weeks before Christmas. Walmart will pay a fortune in overtime, but that could still be less than the fortune it would spend on the hiring process. Amazon’s seasonal hiring is smaller than last year despite estimates of 9 percent revenue growth compared to last year and a new need for tens of thousands of delivery drivers. Improved automation may be the explanation for a smaller seasonal army in Amazon’s warehouses this year. Fear of unions is another reason why Amazon is trying not to employ such a large number of workers doing the same work at the same location. Target is trying to hire a large number of seasonal store employees, but not quite so many as last year. Macy’s, stung by low December traffic after hiring an extraordinary number of seasonal workers in 2017, will not be repeating that mistake this year. JCPenney and Best Buy are the two largest retailers I could find that intend to hire more workers than a year ago, but they are hiring only now, so seasonal workers should expect to work only 100–200 hours in total.

If I had to sum up the seasonal hiring, I would have to say that uncertainty is making companies hesitate. Consumer confidence might be strong, but it does not feel solid. Retail patterns are shifting, with more online shopping than ever before, but consumers also starting to get tired of online shopping. More retail bankruptcies and liquidations are expected, and the impact on any given retailer is hard to predict. With a renegade White House and a divided Congress, there is a palpable risk of a constitutional crisis. To business planners, it looks like a good time to be cautious in plans.

Wednesday, November 7, 2018

Problems in Bankruptcy for Sears

Sears’ bankruptcy filing came with an unusual clause describing financing to be arranged later. I originally thought that the bankruptcy financing would have to be worked out by the beginning of November for the retail giant to avoid Christmas-season liquidation, but that date has passed and there is no sign of the money needed to keep Sears and Kmart stores operating through the end of the year. Last weekend there were whispers of a deal to rescue the Sears retail chain, but apparently financing remained an obstacle and that deal did not come through. Without the planned financing, Sears shelves could be half bare by the time Christmas is here, and mall owners might start proceedings to evict the retailer after rent goes unpaid. Already things are looking desperate on the shelves at Kmart stores according to multiple published reports and video posted online.

There is a second problem. Creditors have asked for a formal review of insider deals at Sears over the last few years. There have been many insider deals between Sears and other companies controlled by its majority owner, deals worth billions of dollars, and some of the deals could end up being reviewed in bankruptcy court. In the worst case, if an investigation reveals an active coverup surrounding the transactions, that could lead to criminal charges against officers at Sears and its counterparties. As unlikely as that scenario might sound, merely raising the possibility of wrongdoing by officers makes it harder than it was already for Sears to arrange financing of any kind or make the kind of large-scale deal that could rescue the company from bankruptcy. Even a delay of a few weeks while the court considers these questions could ruin a deal.

In a practical sense, it is probably already too late to close the remaining Sears and Kmart stores before Christmas. The Christmas shopping season is already well underway, and it reaches its high point in barely three weeks on Black Friday. But a move to put the remaining stores into liquidation after Black Friday, while there are still some Christmas shoppers to sell to, does not seem particularly unlikely. Much depends on the cash flow at Sears stores. In theory, if traffic and sales were strong enough, the company would not need any further financing. But if shoppers stay away, worrying that Sears is not functioning normally or mistakenly believing stores have already closed, Sears will run out of cash before Black Friday, and then there will be no legal mechanism available to stop an early liquidation. Unfortunately, the latter scenario is more likely than the former.

I still believe that removing Sears’ executives provides the only plausible hope of having the company make its way through bankruptcy. Creditors, lenders, and investors have no reason to place any faith in the current management team, the same people who ran two legendary retail names into the ground. The sooner current management can be removed, the better the chances of salvaging something of Sears and Kmart. But so far, there aren’t any moves in that direction.

Update, Friday, November 9: Sears has announced 40 more store closings. The new list is concentrated on the East Coast and includes 29 Sears stores and just 11 Kmart stores. At a glance, it seems fair to guess that these stores are low-performing stores that were mistakenly left off the original list. It could be that the company thought it could find a buyer for some of these stores in bankruptcy because of their favorable locations.

The original store closing list is now said to be closing “in 2018,” which I think in practice means the two weeks after Christmas. Stores on the new list are expected to close “February 2019,” which will surely be January in a few cases. No one should be surprised if 100 more stores are added to this new list. At this point, closing all stores in February would not be a big surprise.

The new store closings do little to close the funding gap. Sears still needs a loan of well over $100 million just to keep the doors open through Christmas, and it is hard to imagine any large bank putting that amount of money at risk just so a failed retailer can keep doing what it was doing already. The only scenario I can imagine is a consortium of five or more banks and hedge funds, but lenders would require a substantial change in management, probably larger than Sears can stomach. Bankruptcy financing deals are not very complicated — the loan contract can be as simple as a two-page memorandum — so if such a compromise were possible and made business sense, the company should have arrived at it by now.

Update, Tuesday, November 13: CNN reports a filing by creditors to put Sears into liquidation. Creditors can hope to get about 4 percent of what they are owed if Sears is liquidated, but fear there will be nothing left if stores stay open for a few more months. The motion apparently originated with mall owners and represents the view of only a small fraction of Sears’ creditors, but it has an immediate legal impact nonetheless. Sears now has to persuade the court that the bankrupt company’s plan works out better for creditors. In that connection, the liquidation filing puts more pressure on Sears to show that it has the financing it needs to stay open through the end of the year. A ruling on the motion to liquidate could happen this week, or the court could decide to wait for Cyber Monday so it can consider the impact of Black Friday revenue.

Update, Thursday, November 15: Bankruptcy court, in a hearing today, has put off a decision on liquidating Sears for one month. Yesterday, Sears obtained a $350 million line of credit which, even if sales are disappointing, should allow it to stay open into January. Realistically, Sears needs to show a reasonably strong holiday season to avoid a liquidation order in December.

Tuesday, October 23, 2018

Hasbro Report Confirms Setback in Toy Sector

Hasbro’s earnings report confirmed what industry analysts had been saying all along: toy manufacturers will lose sales because of the closing of Toys ‘R’ Us. The two largest U.S. toy manufacturers, Mattel and Hasbro, were disproportionately represented on the shelves at Toys ‘R’ Us, so they were expected to see a bigger immediate impact and to lose some sales permanently to other toy manufacturers with the loss of shelf space. There is nothing to indicate that the toy manufacturers are in any financial peril, however. They will be able to scale back production plans and carry on on a slightly smaller scale.

During the earnings call, Hasbro said there should be no long-term impact from Toys ‘R’ Us, but there is nothing to back up that assertion, while reports of layoffs imply that the company expects a permanent loss of a small fraction of sales.

Sunday, October 21, 2018

Christmas Shopping Is Underway, Even at Kmart

The Christmas shopping season is underway. Shoppers were out in force at the local stores I visited this afternoon‚ not in the large numbers of a November weekend, but enough to tell you this is not just an ordinary shopping weekend. Shoppers converged on the checkouts to form the same kind of lines that will be seen with a larger number of cash registers open a month from now.

The strong early start to the Christmas shopping season implies that, like the past six or years, the crush in November and early December may never materialize. For troubled retailers hoping for a big December, like Mattress Firm, Barnes & Noble, and of course, the newly bankrupt Sears and Kmart, the high level of activity in October is not a favorable sign. It implies that December will again be on the sluggish side, with many shoppers having already completed their shopping by then.

One of the stores I visited was the local Kmart store that is set to shut down in bankruptcy in about ten weeks. There were plenty of shoppers in the store even though the store closing sale will probably be starting in about another week. Looking at the store, the only indication of a liquidation underway was a small display of back-to-school items at a deep discount. It was, as they always say in bankruptcy, business as usual.

The shelves were stocked well enough to be credible, but if you looked for them, you could see signs of a business in decline. The company had stopped repairing the floor at least two years back. The ceiling banner that said “Introducing Craftsman,” a marketing message that dates all the way back to the original merger of Sears and Kmart, had surely not been touched in more than ten years.

The merchandise selection, when I looked at it, seemed somewhat dated, though walking into Kmart was not like walking into a time machine. The wall of televisions one might have seen a decade ago is gone, and there are now more iPhone cases for sale than televisions in the electronics section.

It was my first visit to Kmart in about five months, and looking at the items on the shelves I realized why. The specific item I had come to buy, an appliance extension cord, was the kind of item that could be expected to last for 20 to 50 years. Extension cords do not wear out the same way they once did. The same holds true of a wide range of merchandise. One aisle over, there were LED light bulbs that might last half of a human lifetime, right next to the more familiar incandescent bulbs that last about one year. Shoppers who select the LED bulbs, even by accident, will not be back to the same display nearly so soon. At the front of the store, artificial Christmas trees showed the same kind of durable design that might last for decades.

The layout and business model of the traditional department store, which Kmart replicates, is based on the assumption that common items like extension cords will be replaced every few years. With so many items to replace, you return to the store almost every month. There was a time when that theory worked. I remember when I would shop in a department store at least once a month. Without my noticing, that became once or twice a year. The durability of modern manufactured goods is what is killing the department store. I have written about shopping fatigue, consumer time pressure, and e-commerce, and surely these all have their impact, but product durability is the crux of the problem that faces department stores. This implies that the failure and likely liquidation of Sears and Kmart is not good news for Target, Walmart, or Amazon. When products last longer, every retailer has fewer opportunities to sell.

Monday, October 15, 2018

Sears and Kmart in Bankruptcy

The long-awaited Sears bankruptcy filing occurred overnight, and there are reasons to be skeptical. I am relying mainly on the AP story (“U.S. Sears files for bankruptcy protection amid plunging sales, massive debt” at CBC News) since it contains details not found in other early reports. These are the four main points going against Sears and Kmart:

  • History has not been kind to U.S. retailers that file for bankruptcy reorganization at the start of the Christmas shopping season. Those filing in January after a Christmas-season disaster have a shot at survival. A retailer that goes into bankruptcy before Christmas is too deep in debt to put merchandise on the shelves. The first example that comes to mind is Toys ‘R’ Us, a year ago, and of course, that retail chain is long gone.
  • The bankruptcy plan has only half of the financing needed to keep stores open through December. “More financing to be arranged later” translates to “We’re so broke we can’t even go bankrupt.”
  • The reorganization plan is, in so many words, “Stay the course.” Only 142 Sears and Kmart stores will close immediately, in two retail chains that may not have even one profitable store between them. Sears wants to continue the slow, cautious dismantling that has been the plan at Sears for the last ten years, resulting in a loss in almost every quarter. The CEO who was the architect of this downward spiral remains with the company. There is nothing to persuade creditors, investors, suppliers, or a bankruptcy judge that meaningful change is on the way.
  • Most of the assets are gone. Sears lists $6.9 billion in assets, compared to $11.3 billion in liabilities. In the past 11 years, Sears has sold its best store locations. The Canadian subsidiary went into bankruptcy and has already closed. The Land’s End and Craftsman names are gone, the Sears catalog a distant memory. The assets that remain will have to be scrutinized. Some may be less valuable than estimated. Many are surely encumbered in one way or another. There may not be enough assets available to provide the foundation for one retail chain on this scale, let alone two.

A retail bankruptcy can fall into liquidation from just one problem on this scale, and Sears has these four. The most likely outcome, then, is that the last Sears and Kmart stores close no later than April. There are reasons to imagine this happening sooner. First, a bankruptcy court could reasonably reject the bankruptcy plan. After all, “stay the course” is not a plan, and liquidation sales will bring in more money if they can be conducted during the Christmas shopping season. If the planned financing comes through and most stores stay open, that still leaves the bankrupt company out of cash in January. It would have to do something remarkable during the Christmas season to invite new investment that would allow it to continue, but no one goes into a Sears or Kmart store with the word “remarkable” on the tip of their tongue. So this is the big question: how many stores close in the next three months, and how many in the three or four months that follow?

Context and proportion are important. Most Sears and Kmart stores have closed already. At the company’s peak there were thousands of stores. If Sears and Kmart can keep a few hundred stores open for a short time beyond the end of 2018, until those stores close too, it is a footnote in the history of two once-proud retail names.

There could be three rounds of store closings in bankruptcy. There will be the initial list of 142 stores. This list is apparently not yet decided but would have to be announced in October. There could be a followup list of additional stores to close immediately after the after-Christmas sales. The size of this second list will be a sign of the balance of power between lenders and suppliers. Sears’ suppliers are better served if this second round of closings is larger; lenders are more likely to seek to avoid this second round entirely.

After the Christmas sales numbers are in, there would have to be a third list of stores closing because seasonal revenue was too low. This could be a short list if a miracle happens and Sears has a strong season. If the season disappoints, all the stores will close quickly.

Impacts

Workers. Sears employs close to 100,000 workers at its stores. The question workers face is, “Will my store close in December, January, or March?” If you work at the store, your hunch is probably as accurate as anyone’s detailed analysis.

Suppliers. Layoffs are likely at many Sears suppliers, and profit could be affected, especially in the current quarter.

The Kenmore brand. The Kenmore appliance brand will probably be sold at auction. The most likely buyer would be a large appliance manufacturer. Kenmore will be a vanity plate on appliances identical to those already sold under other brand names.

Malls. Sears was once one of the two anchor stores in about half of the malls in the United States. There are some malls, especially in the heartland, where it is the only anchor store still open. There could be dozens of malls that close next year after the Sears store closes.

Toys. Shoppers who needed toys for Christmas already had a chance to buy them at the Toys ‘R’ Us liquidation and will have a second chance as Kmart locations close. Popup toy stores this season will largely go unnoticed. Even next year might be too soon.

The Sears card. As Sears was taking its business apart, it sold off its credit card portfolio. Citibank will probably replace Sears cards with Mastercard cards, though with limited success.

Gift cards. I have never seen a Sears or Kmart gift card, but as always in a retail bankruptcy, if you are holding a gift card, spend it soon.

Sunday, July 22, 2018

The Long Arm of Unintended Consequences

It is no great trick to trace this summer’s rush to meet emissions testing deadlines (Reuters story: VW to temporarily park cars due to new emissions testing bottlenecks) back to 1976 and policy responses to oil price shocks and shortages. After four decades of a push to improve automotive efficiency, countered by a resistance to that push, the automobile industry still has not found a sensible balance.

Those with a deep knowledge of colonialism and its effect of the oil industry can add at least another 30 years to the backstory. When the urge to burn fossil fuels efficiently surfaced in the 1970s, it was a reaction to decades of artificially low prices for fossil fuels. That in turn was possible because the oil and automotive industries and the mining tycoons before them had been leaning on geopolitical muscle to transfer and obscure most of the costs of obtaining and burning fossil fuels. Mine owners and automakers just wanted a smoother path to profit. The parking lots full of untested cars in the summer of 2018 are the unintended consequence of compromises made in haste in the 1860s and 1960s.

My point here is not to explore the details of this particular saga, but to count the years. When things get this far out of whack, it can take a lifetime to get things back into a semblance of balance, a second lifetime to reach an effective functional balance. Just taking the example of gratuitous inefficiencies built into cars, there is little hope that this problem can be fully solved before 2050. After all, designs being drawn up this year will result in cars that are still being driven in 2050.

The time scale is the same as that of finding peace after a war, and it is no accident that political leaders used phrases like “moral equivalent of war,” “war on poverty,” and “culture war” half a lifetime ago to describe imbalances that we are still trying to fix today. If war is hell, a culture war means a culture that embodies the energies of hell. It does not matter whether you think of war or hell — the answer to either is peace. Peace comes about by solving the lingering consequences of the past on the level of one person, one car, one building, and one street.

Chances to solve the problems of past “wars” come up often, and they can be surprisingly mundane. In my life, I think of replacing my low-efficiency refrigerator five years ago or throwing away my NFL team apparel last spring. Don’t underestimate the effect on the future, including your own future, when you can put some form of “war” behind you once and for all.

Tuesday, June 19, 2018

Cigarette Decline Continues

U.S. cigarette use continues its long-term decline, though it can hardly be described as low. The New York Post headline for an AP story is “Smoking in the US is at an all-time low,” though the current 14 percent rate is still a fourth of the rate seen at the all-time high a lifetime ago. There continue to be worries about e-cigarettes and vaping, though it seems those are fading fads now after word of health consequences got out.

Cigarette smoking is declining for two main reasons: a smaller advertising presence and the early death of regular smokers. Tobacco companies are acknowledging that their products are deadly for the first time this week after the companies lost a 2006 racketeering case. The court in that case found that the companies got together to spread false information the dangers of cigarettes. The new court-ordered corrective statements still understate the dangers of cigarette smoking, since they are based only on the information tobacco companies had in 2006. They do not mention, for example, the more recent research implicating exposure to cigarette smoke in cases of sudden death from heart attack.

Other cultural trends are working against cigarettes. Cigarettes are part of a cluster of products and activities that might be seen as the gritty side of 20th-century culture. This cluster also includes beer, soda, coffee, smoked meat, narcotics, boxing, football, golf, sports television, secret societies, men-only lounges, motorcycles, pickup trucks, detective novels, and more — nearly all now in long-term decline as popular culture moves in another direction.

Friday, June 15, 2018

Is IHOP Still in Business?

A consumer brand’s social media efforts are usually directed toward sharpening and humanizing the brand. It is instructive, then, to look at the recent “IHOb” campaign from IHOP, which took the exact opposite approach. It was designed from the beginning to confuse and sow doubt. For a day, the storied pancake restaurant chain was talking about nothing but its format change. The newly renamed IHOb had thrown away its name and its menus. The new smaller menu had little more than an array of international burgers.

There was no human touch in this announcement. It was all preprogrammed and done according to a formula, as if there was no one there at IHOP headquarters, like a radio format change done by machine while the entire on-air and office staff is escorted out. Even the IHOb Twitter replies intended to reassure worried customers that the chefs still knew how to make pancakes appeared to come from a bot.

Customers who saw the announcement were confused. As the change was repeated on Twitter and in the news, the stories ranged from “IHOP is shutting down” to “IHOP thinks it’s going to be the new McDonald’s.” Toward the end of the day IHOP officers tried to reclaim control of the narrative, but with limited success. The public statements that IHOP was not really changing its name came across as a panic move after the rebranding was seen as a failure, or even as an internal scuffle at IHOP headquarters with the outcome undecided. Now that the dust has settled and the story has faded, there probably isn’t anyone who can tell you what really happened at IHOP. No one knows.

This is bad for business. To take your family to IHOP now, you first have to persuade someone that the restaurant is still in business and still has a recognizable menu. If it turns out you’re wrong, you’ll have egg on your face while you walk everyone back to the car. It’s a risk — and is IHOP such a good restaurant that you’re willing to stick your neck out to take people there? In a town with more than one restaurant, the safer move is to go somewhere else.

The impression I am left with, after reading all the news I could find, is that IHOP is attempting a nostalgia angle leaning on the 1950s diner era, but without a budget for period furnishings. In other words, IHOP seems to be trying to take on the failed diner chain Denny’s. It doesn’t make any sense, but I can find no other story that explains the new menu items. I’ve seen photos so I believe the new menu items are real. It’s a move that might appeal to IHOP customers born before 1955, but those who are younger must be forgiven if they feel slighted. Why would a restaurant take such a large step backward in food quality and selection? Has IHOP lost its collective mind? As the McDonald’s and Chipotle stories attest, the American public has not been kind in recent years to restaurant chains that try to turn back the cultural trend toward better food quality. IHOP was selling a menu of near-average food quality, but that is obviously not the case with its new menu. The attempt to move downmarket, apparently without a price cut to support it, could not possibly end well.

Any way you try to parse the story, the result is FUD, the fear, uncertainty, and doubt that may make potential customers hesitate. To be sure, there will be some IHOP regulars who respond with curiosity — “Let’s go over there and see for ourselves.” The broader public, though, no longer knows what IHOP stands for. If IHOP fails to recover from its name change and rebranding, marketing textbooks will record that it destroyed its brand in one day.

Monday, June 4, 2018

Starbucks Revisits Its Stores

Starbucks is trying to get itself out of the predicament it created by ceding control of its cafés. These first two adjustments may be regarded as baby steps, but they show that the company recognizes the problem it faces, if not necessarily the magnitude of the problem. That is a change from the company’s initial reaction to the incident in Philadelphia when a store manager had two customers arrested for no reason. Starbucks’ focus a month ago was on damage control for that one incident. The deep corporate denial about the systemic operational issues was intact at that point, but has softened as executives have taken a closer look.

First company headquarters in Seattle issued a policy change. After a year of official and unofficial experiments with a more aggressive approach to customers, the company seemed to recognize that it might be scaring many its loyal customers away from its cafés. In a change of heart Starbucks said that it would not forcibly remove customers or guests except in unusual circumstances. The policy makes a sincere, if tentative, attempt at writing down what those circumstances might be. As an example, if a customer falls asleep in the café, employees will attempt to wake and speak to the customer. Calling the police will no longer be an option as an initial response.

The things that were not said were just as important in the announcement from Starbucks two weeks ago. After two decades of telling store managers that the company does not know how to run a café, so that the store managers will have to figure it out for themselves, the company is taking the first steps toward reining in the excesses of the store managers it turned loose on its stores. This move is long overdue. It is an incongruous position for the world’s largest café operator to take the position that it has little advice to offer on how to run a café. Starbucks as a company should be the expert in this, certainly more so than the store managers it hires. This policy change reflects that intention. Starbucks has high turnover in its store manager positions, on the order of 50 percent per year, and most new store managers have no previous café, restaurant, retail, or hospitality experience, so the lack of operational guidance creates unnecessary stress for managers and customers alike at nearly every Starbucks location. No one expects a rush of manager firings to follow, but the explicitly stated policy tells all levels of management that store managers can no longer do whatever they please as long as their stores are eventually profitable.

Then Starbucks held its much-publicized racial sensitivity training. It was not the full day of training that some of the company statements had implied, but a half day at most locations. In other respects, though, it was a bigger initiative than one might expect from any corporate training program. This was not canned training put together at headquarters but was guided by outside experts. The training curriculum and materials were not stuck in the formulaic thinking that rules any corporate headquarters. Workers told me of meaningful discussion questions and exercises that led them to see everyday situations from a broad range of points of view.

This was also a highly visible exercise, as stores had to close halfway through the day, something customers have never seen before except in emergency situations such as severe weather or utility failures. Customer reaction was more positive than negative, with a few customers making a point of visiting the stores the next morning to show their support.

It is not enough. In most matters, Starbucks is still telling its store managers to make it up as they go along. For example, stores still run out of essential supplies as early as two hours after opening. As an occasional Starbucks customer, I am reassured enough that I would enter a Starbucks location again if I had a reason to, but I still hope I don’t have to — at least not yet, not until Starbucks has time to take the next steps to get its stores under control.

Monday, April 23, 2018

“Fire Your Customer” Reaches Consumer Retail, With Disastrous Results

Two racial profiling incidents, days apart. A Starbucks manager in Philadelphia called the police on two customers almost as soon as they walked in the door. The police arrived quickly and arrested the two for trespassing. The Starbucks CEO had to fly in from Seattle to sort out the situation. The charges were dropped, the manager, removed from duty but not fired. Three LA Fitness employees in Secaucus, New Jersey, called the police on a member and guest, again claiming trespassing. The police arrived but found no reason to arrest the two. The staff nevertheless ejected the two customers, telling the member he was banned from the club for life. Again executives had to sort the matter out. The three employees were fired, the member, reinstated.

What happened? Activists and executives alike concluded that these were simple cases of racial profiling. All four of the customers accused of trespassing were black. Staffers singled them out for hostile treatment because of their race. Blinded by racial prejudice, staff members looked at perfectly ordinary customers and saw them as a menace.

No doubt that is accurate, but there is more to it than that. No one would claim that either Starbucks or LA Fitness can succeed based only on its white customers. Executives and store staff would agree that the store’s success depends on having as many customers as possible — and even filling the store with customers is no guarantee of success. So where did this idea of having customers arrested come from? Furthermore, it is not just the nonwhite customers who are shaken up by seeing these events unfold.

Starbucks and the Syms Incident

Personally, I am particularly troubled by the Starbucks arrests, and it is not just because I saw them on video. The timeline is more troubling than the video. A Starbucks manager glanced at two customers and decided instantly that they were troublemakers, dangerous enough that the police would have to be called to remove them. I’ve had that experience — when people in a position of authority look at me and decide at a glance I am a troublemaker. When I was in school, I was a model student, but there were teachers who hated me instantly and forever, and earning straight A’s didn’t change their minds about me. I expect this, though of course it is not as frequent today as it was when I was younger. I am a rock musician and look like it. There are millions of people in America, surely more than 1 in 100, who would like to see all rock musicians and their fans locked up. It is a matter of religious faith for most of them. They will never change their minds. So how many of them are Starbucks store managers? Is it safe for me to go back into a newly aggressive Starbucks? The company hasn’t breathed a word of reassurance, so it remains an open question, and in the meantime, I haven’t been to a Starbucks.

How long before I go back to Starbucks? I am reminded of my experience at Syms, a clothing discounter. I always liked the idea of discounts so at one time it was my favorite clothing store. I must have spent thousands of dollars there. Then one day a sales representative hounded me out of the store. I think he must have taken me for a shoplifter based on my appearance and the fact that I was shopping for clothing for people other than myself. I was shaken to see how I had been profiled and targeted. I left the store quickly. At the time I told myself it was no big deal. Five years went by before I noticed that I had never gone back. A few years after that, I heard that Syms had failed and was going out of business. I went to the store one last time to see what I could buy at the liquidation sale, but my local store had already closed.

I was not the customer targeted in Starbucks’ new policy taking a more aggressive approach to its customers, but I so easily could have been. And while Starbucks is disavowing the racism behind the Philadelphia arrests, it is standing by its policies in all other respects. Is it safe for people like me to go back into Starbucks? I am not sure it is. One thing is certain. Starbucks is not the same company that it was a year or two ago.

Syms had multiple problems. Toward the end, its buyers were having trouble buying the well-designed clothing that the store was known for. Formal business clothing, surely its most profitable department, had just gone into a long-term decline. Still, treating its loyal customers with suspicion and driving many of them away could not have helped its prospects. Now Starbucks had decided to go down that same road. It won’t end well for Starbucks either, as I will eventually explain.

Customer Value

Both the Starbucks arrests and the LA Fitness police call have the hallmarks of a fire-your-customer event gone badly wrong. Perhaps “gone badly wrong” is the wrong way of putting it. From a corporate perspective, any false police report that turns into a public relations fiasco has gone badly wrong. But these incidents were wrong even before the police were called. The decision to expel the customers was wrong from the start. The starkly different reactions of the two companies when the respective incidents came to light shows a real difference in strategy between them. But first, what does it mean to fire your customer?

“Fire your customer” arises from the relatively recent discovery that some customers are more valuable to a business than others. It is not easy, never a fully valid exercise, to quantify the profit a business draws from an individual customer. A business is the combined effort of serving all of its customers. It isn’t literally correct to slice up the business into different parts for different customers. Nevertheless, there are meaningful ways to approach this problem, and the results are conclusive and surprising. In the typical business, a small fraction of customers provide most of the profit. The typical customer is not profitable at all. This last conclusion can be debated endlessly. With small changes in assumptions, you can conclude that the common customer types are generating either a very small loss or a very small profit, but this difference doesn’t matter.

The essential conclusion you must come away with is that the typical customers are not keeping the company in business. This realization busts a myth that business had labored under for five centuries. This remains our cultural assumption about business even though we have known for a generation that it is false. We imagine a business with thousands of customers, each one bringing in a small amount of money. Combined, this is a lot of money, enough to keep the company in business. It’s a nice picture. It is simply not true. The customer that contributes in a meaningful way to the profitability of a business is the rare exception.

When quantitative marketing analysts (such as myself) consider the customer base of a business, one of the first and most important distinctions we make is an attempt to separate the high value customers, the ones we think contribute to profitability, from the low value customers, the ones who contribute little or nothing to the profitability of the business. This customer segmentation is never perfect, but it is rarely subtle. In formal business clothing, for example, the high value customer is one who buys suits two or three at a time, multiple times per year. The business will never make a healthy profit on the customer who buys one suit at a time, no matter how often.

In an accounting fantasy, you could make a business more profitable by taking away all the low value customers leaving the business with a much smaller base of high value customers. As far as I know, it is with this concept that the “fire your customer” idea was born. In the fantasy world, your business keeps the 5 percent of customers who provide 80 percent of the profit. You’re doing 5 percent of the work, but getting 80 percent of the reward. Sounds pretty good, right?

The Unprofitable Customer

“Fire your customer” is the rallying cry. In its most extreme form, the objective is to refuse to serve, or “fire,” the masses of customers who don’t directly add anything to your bottom line. In rare cases, this might work. Imagine a print shop with 10,000 customers. It studies its customer base and finds that almost all of its profit comes from 18 customers — customers it barely thinks about as it spends most of its time on its largest customers. The president goes to talk to these 18 customers one by one and they all seem to agree with the idea that the print shop could scale down drastically so it can devote more attention on their jobs. The print shop closes its doors and lays off most of its staff. The workers who remain are doing work only for these remaining 18 customers. The business might even become more profitable than before as it finds ways to expand on the work it does for its 18 private customers. On the other hand, as far as the world is concerned, it is almost the same as shutting the business down. The doors are locked, and the print shop is no longer talking to the public. Most of the workers have lost their jobs. Their customers, other than the few private customers that remain, have lost a supplier. It might be the best outcome for the workers and customers who remain, and perhaps those gains outweigh the losses. But it’s still a drastic change, and that points to why the fire-your-customer strategy doesn’t work for very many businesses.

Fire your customer doesn’t work because after you’re done, the business you started out with no longer exists. To see this in stark relief, imagine that a restaurant refuses reservations from 90 percent of its customers out so it can only serve the few dozen customers who order the high-priced entrees and leave large tips. In an emergency, if the kitchen has almost run out of food, this might make sense, but it won’t work as an ongoing strategy. Do the few high-value customers want to eat in an empty dining room? No. They come to the restaurant not just for the food, but for the atmosphere. Without the customers, the atmosphere is gone. In the meantime, how can the restaurant ever bring in new customers if it is refusing reservations from people it does not know? Will there be enough qualified referrals from the existing customers to keep the restaurant in business? Probably not.

There are other ways that firing your unprofitable customers just doesn’t work. Knowledge@Wharton points out that a business with only profitable customers is especially vulnerable to poaching. That is, competitors will do anything they can to take away the customers of such a business, knowing that any such customer is likely to be profitable. Researchers think this may be the main reason why no fire-your-customers approach, no matter how well planned, ever seems to make a business more profitable in practice.

It is impossible to guess when an “unprofitable” customer may suddenly become important. A business may need a large number of customers to have the reputation that it takes to bring in new profitable customers. An unprofitable customer turns into a profitable customer at random times that a business can’t possibly predict.

Restaurant chain Denny’s tried the fire-your-customer strategy on the largest scale of any business I know of, and the attempt not only failed, but it ruined the company’s reputation and effectively drove it out of business. Denny’s decided its best customers were a certain demographic segment, never mind what that segment was, and it deliberately mistreated all customers who didn’t fit that profile. I can vouch for that because I was one of the customers who was mistreated. Items I ordered weren’t delivered to the table. The bowl of chili was hot on the outside but still icy in the middle. Denny’s was trying to get rid of me. The reason I am convinced of this is that these incidents never happened when I was accompanied by a member of their preferred demographic — on those occasions I was treated well. Of course, we have heard stories from Denny’s that were much worse than anything I experienced myself.

It is easy to see how this strategy backfired. Denny’s made a negative impression on an enormous number of people, literally more than half of its potential customers. Many of the people who they drove out were acquaintances and family members of the demographic they were trying to reach. Indirectly, their preferred customer group got a negative impression too, or they had to go elsewhere because they were dining with a group. In the end, the publicity was so bad that even people who had never heard a personal account of mistreatment at Denny’s decided they were safer to stay away. A brand doesn’t recover from that kind of negative publicity.

Fire Your Customer

If fire your customer doesn’t work as a way to reduce the number of low-value customers, then what is it good for? Marketing experts agree you can’t “fire” a large number of customers, so the strategy has to be reserved for customers who represent a real problem. These might be the customers who are never happy, no matter how good the service is. There are customers who are simply bad for employee morale. Some customers clash a business’s values and principles. Others are constantly trying to take advantage of you in some way or have shown that they can’t be trusted. These are the customers you fire. But if you are firing more than a few customers, it’s not your customers. If that happens, there is something that is fundamentally wrong with the business or the way it is presented.

A classic example of a failure here is Sprint, which decided at one point to cancel the mobile phone contracts of all customers who had made multiple customer service calls per month. The accounting looked sound: these were customers who cost more in call-center time than the company could possibly cover with the monthly subscription fees. Yet it was all a big mistake. The customers Sprint fired were not voluntarily calling Sprint customer service so often. They were calling because the company continued to make operational errors on their accounts, so that their service was interrupted or they were billed incorrectly again and again. By firing these customers, Sprint missed the chance to focus in on and correct some of its worst operational failings — fixes it needed to make urgently because the errors were costing the company tens of millions of dollars a year in extra work. By blaming the customers instead of taking responsibility for its own operations, Sprint not only procrastinated on the improvements it needed to make, it also gave a very poor impression to a very large number of people and created a public relations problem larger in financial terms than the problem it thought it was solving.

Seth Godin explains the principles of “fire your customer” in the short post “The Customer is Always Right.” One of the key principles he and others mention is that you must do your best to make a good impression on the customer you are firing. If the person you are facing is your former customer, your reputation is still on the line. The is a principle Sprint failed to think of when it cut off close to a million customers without having taken time to look into the customers’ very real complaints. Needless to say, the strategy did not lead to the savings and customer growth Sprint had been planning on.

You can’t fire very many customers without savaging your company’s reputation, so it is a strategy you have to use sparingly and strategically. It’s not the answer for every unprofitable customer, only for a few problem customers. It has to be only a few. If it seems you are seeing bad customers everywhere you turn, those are not bad customers. That is just a bad business.

CRM and Consumer Retail

The concept of customer value comes from the relatively new field of customer relationship management, or CRM. Some marketing experts take a narrower view of the field and refer to customer value management, or CVM. The objective of either CRM or CVM is to know what a customer means to the company and manage the customer relationship accordingly. The first part, knowing what a customer means to a company, depends on analytics frameworks that are not yet fully mature at this point, though they can provide useful guidance. In the last three years retail customer analytics have advanced to the point where retail store managers and even retail workers can get a meaningful sense of customer value. The customer value concept is making its way into consumer retail, and for the first time the analytic measures are detailed enough that the customer value score is not just a shot in the dark.

If the concept of customer value is just now trickling into in-store retail operations, it is arriving without the customer-specific analytics that make it work. CRM assumes you know who the customer is so that you can look up that specific customer’s history. At this point, this is still easier to do online or on the phone than in-store. Nevertheless, store workers must be starting to hear how little profit potential there is in the average customer. This is a particularly difficult thing to hear if you are a store manager and held responsible for bringing in more customers and making your store profitable. It must be tempting to try to reduce the number of low-value customers while increasing the number of high-value customers, in spite of the marketing experts who say this doesn’t work.

One area where retailers could do a lot better is with loyalty programs such as the frequent-shopper cards you might have in your wallet. When you study loyalty programs, it is the rare exception that they reach out to high-value customers. Most of the time, a loyalty program is geared directly toward the low-value customers, encouraging them to stay with the retailer and giving them extra discounts as an incentive to stay even though the retailer is already losing money on them. Retailers need to look for ways to redesign loyalty programs so that they preferentially attract high-value customers. They shouldn’t be going to such lengths to retain low-value customers.

The principles of CRM and customer value are simple enough. It is important to retain high-value customers and impress low-value customers. If these ideas are applied correctly, they won’t do much harm even if you are often mistaken about what a customer’s value is.

But if the concept of customer value is applied badly, starting with a fire-your-customer approach to low-value customers and compounding the error with a series of mistaken assumptions about what a customer’s value is, I think it’s obvious that the result can be chaos. My guess is that this is what happened both at Starbucks and at LA Fitness. Two store managers mistakenly thought they saw a threat to their profitability, and they panicked. If it can happen to these two managers, it will happen again. The more data retail managers see that shows them how little profit their ordinary customers provide, the less generous they will feel toward those customers. The way it looks to me, this is just the beginning. Fire your customer has just barely reached the retail space, and it is already a disaster.

Rogue Store Managers

In both places the actions can be attributed to rogue store managers, and the respective companies have publicly taken that stance. It fits well enough that not many will question it. If your first thought on seeing a customer you don’t recognize, who is acting essentially the way you expect from a customer, is, “We’ve got to get rid of this pesky customer,” then you may not be fit to work in retail at all. This degree of hostility toward ordinary customers is a fireable offense all by itself in a retail establishment. Dialing 911 and making a false statement to the emergency dispatcher, and subsequently to the police, turns a fireable offense into probably a criminal offense. A company that faces the public can’t put up with either from a store manager.

The rogue manager story almost covers the LA Fitness incident. Part of the reason I say that is that it is obvious that the staff was acting against their company’s interests. A health club has high fixed costs and sells on a subscription basis. It needs a large number of customers. Outside of busy city centers there are no health clubs that really have enough customers. Everyone who has been around a health club for a few years knows this, but even if the manager did not, LA Fitness staff are well trained and would have been trained in the company’s business model. The last thing you can afford to do in this kind of business is to tell a paid subscriber who is doing nothing more than acting like a paying customer that he is banned for life. It is no wonder if the CEO was infuriated to hear it. Even if the subscriber was seen as a unregistered guest, a club manager would still have the responsibility to try to sell him a subscription. But it was the club manager who checked in the customer when he arrived at the club, so the manager knew or should have known from the start that this was a paying customer. Somehow the manager saw a problem customer. It is hard to explain as a matter of confusion, hard to escape the conclusion of racial profiling and a rogue strategy of excluding a demographic class of customers.

It is also clear that the Starbucks manager was knowingly departing from company policy, just knowing how quickly she called the police after the customers entered the store. You know for a fact that no one from the store had a meaningful conversation with the two customers because they were not in the store long enough for that to have happened. There is nothing in Starbucks policy that says a customer has to place an order within a certain number of seconds after arriving in a store. It that is a policy in that store, it is one that the local management made up in a departure from company policy.

Despite this, the rogue manager story doesn’t quite hold up in the Starbucks story. In contrast to LA Fitness, Starbucks store staff are virtually untrained, and that includes store managers and the managers they report to. Managers also get shockingly little corporate support. There isn’t a clear system in place for how to do the basics of store operation, such as ordering supplies. This is why Starbucks stores are constantly running out of essential supplies — cups, lids, milk, napkins, pastries. Store managers are pretty much on their own in figuring these things out. You have to get to the third level of management, a manager responsible for maybe 40 or 50 stores, before you reach someone who is reasonably well informed on the Starbucks way of doing things. The store managers are encouraged to find their own ways of making each store profitable. And store managers are held responsible for store profitability, so they are under pressure to find solutions that might skirt company policy or even run afoul of the law if that’s what it takes. In this sense, every Starbucks store manager is a rogue manager, and that is by design. So Starbucks as a company can hardly sidestep its culpability by shifting the blame to a rogue manager. Starbucks barely knows what goes on in its stores, and it doesn’t really want to know. As troubles mount, it will eventually have to start paying attention, but the lack of reaction to the Philadelphia arrests suggests that the company is not yet taking its problems seriously.

Starbucks’ More Aggressive Tone, and Why It Could End Badly

There is another, larger reason why Starbucks cannot blame the incident on one rogue manager. Starbucks has shifted its approach in the last half year in a way that suggests corporate management has bought into the flawed version of customer value theory and is trying to reduce the number of low-value customers it has in stores while increasing the number of high-value customers. This builds on Starbucks’ efforts of the four previous years in promoting its mobile ordering app, drive-through windows, and loyalty programs. Starbucks seems to be trying to boost its business among its most frequent customers while reducing the labor costs of serving them. It wants to see fewer of the new and casual customers who are the most labor-intensive customers to serve. It is trying to make customers a little less comfortable in its cafés. As far as I can tell, this last change in strategy is the reason Starbucks headquarters ordered the new locks on the restrooms at the store in Philadelphia where the customer arrests took place. Extrapolating, it looks like Starbucks intends to be little more than a drive-through five years from now. I have heard Starbucks managers say out loud that we might eventually see all chairs removed from the café so that customers have no place to sit down.

Obviously that would be a drastic change. Yet as marketing experts have advised, you don’t undertake a broad fire-your-customer strategy and still have the same business standing when you are done. Starbucks knows this. It employs marketing experts and understands marketing better than most businesses. The reason its recent changes have been made so quietly is that the company is trying to delay the inevitable loss of customers that it knows is coming.

But I believe Starbucks is making a mistake. There is a reason to believe that Starbucks’ fire-your-customer strategy will undercut the core of its business. To see this, think of the most profitable transaction a Starbucks location is likely to have on a given day. This could be a customer purchasing 10 quarts of coffee and 15 pastries for a business meeting. If the customer has called ahead so that the coffee is ready, the store can make an hour’s worth of profit in five minutes. Who wouldn’t want more customers like that?

But consider why the business-meeting customer is possible. A business orders from Starbucks to impress on meeting attendees that the company has spared no expense in preparing such an important meeting. It is possible to make this impression only if most of the people attending the meeting have experienced Starbucks before. Most commonly they do so by going into the store as individual customers before 9 a.m. and ordering a cup of coffee and one other item — the most typical Starbucks customer, but also just about the lowest-value customer transaction Starbucks can imagine. The high-value customer is possible only because of a much larger number of low-value customers. This is what almost all businesses find when they analyze customer value. If Starbucks is successful enough in driving out the low-value customers, so that ordinary office workers lose their connection to the chain, the high-value office-meeting customer will stop going there. There won’t be any point in getting Starbucks coffee for a meeting if no one attending the meeting knows what that means. Without the low-value customers, the high-value customers fall away too, perhaps not immediately, but with a lag of no more than a few years.

In a similar way, if Starbucks succeeds in making customers less comfortable, customers will no longer think of it as a place to hang out with friends for an hour or as the place to go for a low-key first date. But then, those same customers are less likely to think of Starbucks when they want something special. If you lose customers for one type of transaction, you lose them for the other type too. The end game for this strategy is that Starbucks is the go-to place for coffee addicts seeking high-quality coffee, and hardly anyone else. Yet my belief is that that customer base won’t stand up either.

Consider the history of Starbucks. Starting in the late 1980s, Starbucks rescued a coffee culture that seemed to be in terminal decline. It did this by promising high-quality coffee and a friendly, fun environment. Starbucks is already not much fun anymore, and now it is losing the friendly part too. Then take away the casual customers, and even the hardcore addicts will notice the difference. It will seem as if the life has been sucked out of the place. This is the inevitable result because hardcore addicts, even if addicted to a drug as mild as coffee, can never be very lively. Lively and addicted don’t naturally go together.

It also looks bad to be going to a place frequented only by addicts. If it comes to that, people will be embarrassed to admit that they are regular Starbucks customers. Beyond that, there is the risk of a cultural shift if coffee addicts someday notice how they are being played by the coffee industry — a nightmare scenario for Starbucks that becomes more plausible if its customer base is reduced to just one class of customers. Coffee is not really as addictive as that. Half of coffee addicts could give it up entirely in less than six months just out of spite or shame. As unlikely as it sounds today, this could happen if the coffee industry is no longer propped up by Starbucks’ reputation. Starbucks is playing with fire in liquidating its reputation.

Starbucks’ Bungled Response

Starbucks’ response to the Philadelphia arrests has done little to reassure its regular customers. Starbucks, I believe, is correct to focus on the problem of racial profiling and unconscious bias as a way of defusing a volatile situation. Promising a day of in-store training to its staff on this subject is a good step. However, the training being planned appears to fall short of what was promised, and Starbucks has not said a word about addressing its underlying problems.

The training. Closing the store for a full day of training? It sounds like a strong move, but I am told it will be only half a day of training. And what will the training cover? From what I am hearing so far, it will not be limited to avoiding racial bias. It will also, and perhaps primarily, cover the topic of how store employees should respond to protests. It also does not look good that Starbucks’ main emphasis in this regard is the steps workers can take to minimize property damage. There is a brief mention of customer safety, employee safety, and cooperating with police, but Starbucks’ biggest fear is the cost of replacing the windows that might be broken or cleaning any spray-paint from vandals. The emphasis on defending the premises is demoralizing to some Starbucks employees I have read accounts from. Is Starbucks responding to its racist gaffe by digging its heels in? Does the company expect to repeat this kind of mistake after the CEO said publicly that it wouldn’t? Is every Starbucks location expecting to see picketers?

So maybe the “day” of training will include a solid hour of racial bias training. That hardly seems enough, but it could do some good. But what of the other issues? This is the only major training initiative Starbucks has undertaken in at least five years. Will it start to train store managers on the Starbucks way, so that Starbucks culture is no longer just a nice idea that lives in Seattle? Will it start checking in on its stores in a meaningful way? Will it do anything to address the extremely high turnover among its store staff? Will it find a way to respond more quickly when store managers make major errors? In every case, the answer appears to be no.

Most of all, customers want to know what has changed and what to expect from Starbucks now, and the company so far is keeping us in suspense. As customers, we can see that there are some customers Starbucks wants to keep and other customers it no longer wants to have around, and it is clear enough that this distinction is not meant to be made on the basis of race, but beyond this, we are left guessing. Customers are not abandoning Starbucks yet, at least not in large numbers, but after another incident, and then another after that, almost every Starbucks customer will start to have second thoughts, similar to the way the most loyal Chipotle Mexican Grill customers acknowledge they are taking a calculated risk in eating there after that chain’s endless series of foodborne illnesses. Do I want a good cup of coffee? Starbucks customers will ask. Yes. Is it worth the risk? Well, maybe just this one time.

Customer Beware

The phrase caveat emptor is written in Latin because it refers to a particular problem in ancient Rome. Vendors would sell substandard merchandise to unsuspecting buyers. Setting aside that caution about the goods, the essential social contract between a public-facing vendor and the public has remained essentially intact for the entire time since, a period of at least 25 centuries. One side of the contract says that essentially anyone can go into a public-facing retail space and can take the actions that the place implies. The reason that LA Fitness and Starbucks calling the police on their respective customers is so shocking is that it breaks this social contract. When a powerful institution breaks a social contract, everyone pays attention because suddenly we don’t know what to expect from the world.

In this sense, the breach from LA Fitness is not so unsettling, and accordingly has not drawn so much attention, because the company took it all back in emphatic fashion. The breach from Starbucks is far more unsettling. Starbucks has disowned the arrests but not the changes in policy and approach that led to the arrests. Starbucks is still a place for people to hang out, but in a more limited fashion than you would traditionally expect from a coffee shop, and we don’t know what the new rules are. The social contract is normally assumed and so internalized that it is barely conscious, so when it is broken, people who were confident about their place in the world start to question everything, and that is starting to happen in response to the Starbucks arrests. This explains the enormous scale of the reaction to the incident at Starbucks. Two business men were arrested just for walking into Starbucks and sitting down? What is the world turning into?

It would not be so earth-shattering if these were just isolated incidents, but no one believes that. The Syms episode I related happened many years ago, and certain department stores have had a much worse reputation for a longer period of time for profiling and targeting their customers. What we are seeing now is just a new and more pointed version of the same thing. This kind of behavior from retailers could become more common for years to come as more retail managers gain progressively more data on how little profit the average customer is providing. Even though only a small fraction of stores will resort to throwing people out, I expect every single one of us will be profiled and expelled from a retail space at least once, not because we did something wrong, but just because someone thought we looked unprofitable or we did not look like a match for the customer profile that someone was hoping to see. When it happens to you, it will still be upsetting, but at least you can realize that you are not the first. Retail chains under financial pressure will tend to be the quickest to adopt the fire-your-customer approach, and doing so will hasten their decline, as the related profiling and targeting may have done in the case of Syms.

When the social contract starts to break, the results can be unpredictable. The retail space is struggling financially and struggling to adapt to the loss of anonymity for shoppers, long a fact of life online but now inching its way into stores. With retail already in turmoil, a generation of retail managers is facing what they now realize are mostly unprofitable customers, and too often, making snap decisions. A disaster is already upon us — just look at Starbucks and LA Fitness — and an upheaval is inevitable even if we cannot predict much of the outline of the changes ahead. For lifetimes we have taken for granted that we can go into a shop and buy what the shop is selling. When something as basic as that is no longer valid, we have little choice but to start questioning everything.